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Certificate Program in Payment Systems Domain Competency Academy

Competency V 2.0

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.

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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.

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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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

• 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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

• 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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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).

<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)
Figure 3.4 Specimen of Promissory note
with interest @ 9% per annum, for value received.

Signed Preetum
Stamp
To Preetum
Chennai

Figure 3.3 Specimen of promissory note

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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.

<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

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.

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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.

<Date>

Pay…………………………………………………………………………..
……………………………………………………………………or Bearer
Rupees………………………………………………………………………
……………………………………………………………...Rs……………

CANARA BANK
Banjara Hills,
Hyderabad
MSBL/99

65303 110002056 10

Figure 3.5 Specimen of a cheque

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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.

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.

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).

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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

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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

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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

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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 Allows information collection, maintenance and
review 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 Enables inventory management, including
Marketing information collaboration, replenishment, price protection,
management reporting and allocation of constrained products.
Marketing information Enables communication of marketing information,
management including campaign plans, lead information and design
registration

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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

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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

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• 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

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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.

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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

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List of tables

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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.

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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.

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• 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.

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• 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.

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• 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

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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.

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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.

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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.

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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

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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

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• 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)

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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.

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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 support@swift.com.

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

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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.

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.

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

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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).

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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.

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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

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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

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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.

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Chapter-19 Mobile Payments
V 2.0, April 2009
for associates

Certification Program in Payment Systems Competency V_2.0

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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.

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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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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

17.2. Learning Objectives


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
17.2. Learning Objectives .............................................................................................................. 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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

• 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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

Personal Account Premier/Business Account

Open an Account Free Free

Send Money Free Free

Free for bank accounts in the US. Free for bank accounts in the US.
Withdraw Funds
Fees for other banks Fees for other banks

Add Funds Free Free

Receive payments
funded by PayPal
Free 1.9% to 2.9% + $0.30 USD
Balance, PayPal Instant
Transfer or PayPal eCheck

Receive payments 4.9% + $0.30 USD (limit of 5


funded by Credit Card, transactions per 12 month
Debit Card or Buyer period)** for domestic or U.S.
Credit transactions
2% + applicable Fees for cross 1.9% to 2.9% + $0.30 USD
border payments.
4.9% plus $0.30 USD for card
payments received using PayPal
on Skype

Exchange rate includes a 2.5%


Exchange rate includes a 2.5%
Multiple Currency fee**
fee**
Transactions Fees for cross border payments
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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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.

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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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:

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“(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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

• 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

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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
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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
the “Buy” button. A message is sent to the website regarding the consumer’s desire to
buy and make payment.
2 - The Web store’s server, after receiving the message from the buyer, 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.
3 - Based on the Digital Certificate, the Payment Gateway authenticates the web store.
4 - The Payment Gateway offers various payment options on a screen to the buyer.
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
the “Buy” button. A message is sent to the website regarding the consumer’s desire to
buy and make payment.
2 - The Web store’s server, after receiving the message from the buyer, 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.
3 - Based on the Digital Certificate, the Payment Gateway authenticates the web store.
4 - The Payment Gateway offers various payment options on a screen to the buyer.
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
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
Client Module Bank Client Module facilitates interaction with the
Banking System and also keeps track of the transaction.
This module enables the user to register with the
User Registration Module Electronic Payment Services. The user must have a
digital certificate from one of the participating banks.
This module helps the payee notify the system
Payment Maintenance Module regarding the payments due. The module also accepts
payments and maintains payment status.
This module undertakes the encryption, decryption and
Security Module signing functionalities.

The module manages various payments instruments


Payment Handler Module and the related validations.

This manages the communication functionality with


Communication Module other systems.

This module archives all the information regularly and


handles the recovery procedures to ensure high
Backup & Recovery Module availability; it helps transfer information to another
server.
This provides the interface to Web to access electronic
payment services. It also acts as the interface between
Web Interface Module 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

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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.

Internet

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

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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

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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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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 Requires API
easy and fully
NO calls -
Payment Pages brand able
cumbersome

Integration Process
Java (JSP) /
Specifications
Available Integration Kits ASP/ PHP/ Java / DLL
only
Perl
Checksum SSL Socket SSL Socket
Method for passing integration parameters based based based

Level of Integration Difficulty LOW High High

Less than 1 Several hours Several hours to


Typical Integration time hour to days days

Fraud Prevention and Risk Mitigation *Important*


Instant Fraud Alert Mails for risky Transactions YES NO NO

Heuristic Fraud Pattern Matching and detection engine YES NO NO

Customisable Alert and Action criteria for Risky


YES NO NO
transactions

Comprehensive daily reports with Risk Scores per


YES NO NO
Transaction

Partial Captures and Refunds YES YES YES

Cost

Rs 75,000 or Rs 75,000 or
Set Up Rs 20000/-
greater greater

5% per 5% per 5% per


Transaction Discounting rate
transaction transaction transaction

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

Rs 5000 to NIL Rs 5000 to NIL


Monthly Rental fee NIL (volume (volume
dependant) dependant)

10% - 30% of 10% - 30% of


estimated estimated
Initial Reserved Deposit NIL
transaction transaction
volume volume

Support

24 x 7 Helpdesk YES NO NO

Comprehensive Online Knowledgebase YES 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

Immediate to 1 week or 1 week or


Approval Time
24 hours greater 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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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.

20.2. Learning Objectives


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.

20.3. Topics Covered


Chapter-20 E-Money ....................................................................................................................................... 3
20.1. Introduction.............................................................................................................................. 3
20.2. Learning Objectives .............................................................................................................. 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?

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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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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)

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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.

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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

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– 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.

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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

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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

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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.

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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

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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.

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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.

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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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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

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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.

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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

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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.

21.2. Learning Objectives


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.

21.3. Topics Covered


Chapter 21- Risks and Liquidity Issues..................................................................................................... 3
21.1. Introduction.............................................................................................................................. 3
21.2. Learning Objectives .............................................................................................................. 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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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 Proportion of loss to be Actual value borne(in
towards bank A (all in shared crores)
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

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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.

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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.

22.2. Learning Objectives


After completing this chapter you would know more about
• Regulatory bodies in the context of the payments scenario
• And the associated various Regulations.

22.3. Topics Covered


Chapter-22 Role of Regulatory Bodies..................................................................................................... 3
22.1. Introduction.............................................................................................................................. 3
22.2. Learning Objectives .............................................................................................................. 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

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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

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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;

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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

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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;

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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

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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. 210.26 - Definitions.
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

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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. 229.2 - Definitions.
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. 205.2 - Definitions.
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.

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Chapter-23 Role of Non-bank Institutions in
Payment systems
V 2.0, April 2009
for associates

Certification Program in Payment Systems Competency V_2.0

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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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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).

23.3. Topics Covered


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

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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

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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

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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.

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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
1. The consumer writes a check for goods or services at a merchant location.
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)
• Present a cash letter to the Fed;
• 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)
• 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 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

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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.

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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.

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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
1. The consumer writes a check for goods or services at a merchant location.
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
1. The consumer writes a check for goods and/or services at a merchant location.
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
1. The consumer writes a check for goods and/or services at a merchant location.
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

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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
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.

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Settlement
Settlement is dependent 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.

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
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.

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Settlement
Settlement is dependent 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.

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.

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.

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

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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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Chapter-4 Clearing and Settlement System
V 2.0, April 2009
for associates

Certification Program in Payment Systems Competency V_2.0

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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.

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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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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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

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:

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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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