Payment Systems Part 1
Payment Systems Part 1
Payment Systems Part 1
Competency V 2.0
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.
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.
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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.
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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.
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.
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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.
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)
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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.
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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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).
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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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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.
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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.
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important. Relevant factors in its supply will include the depth of inter-bank money
markets and the availability of any relevant collateral. With the benefits of smooth
payment flows in mind, the central bank should consider whether and how to provide
intraday liquidity to support a system’s daily functioning.
The technology and operating procedures used to provide payment services should be
consistent with the types of services demanded by users, reflecting the stage of
economic development of the markets served. The design of the payment system
should therefore be appropriate for the country’s geography, its population
distribution other demographic factors and its infrastructure (such as
telecommunications, transportation and banking structure). A particular design or
technological solution which is right for one country may not be right for another.
The design of the payment systems thus can be outlined as:
General
• Define objectives (identifying risk and efficiency factors)
• Identify user needs and constraints
• Identify system choices and benefits
• Determine social and private costs
• Develop decision choices.
Analytical framework
• Identify efficiency requirements (or conversely identify inefficiencies)
• Identify safety requirements
• Evaluate costs (social and private)
• Identify resources (social or private)
• Determine practical constraints (technology, infrastructure)
• Define safety constraints (e.g. applying the Core Principles)
Methods
• Cost-benefit or other structured analysis
• Involvement of participants and/or users in discussions
• Methodology for data collection and analysis
• Identify data sources (archived data, economic data, samples or estimates)
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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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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.
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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.
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The range of payment instruments available in any particular country will necessarily
reflect that country’s historical and social background. However, it is important that the
choice should also as far as possible be a reflection of that country’s developing non-
cash payment requirements.
Credit: A granting of loan and creation of debt it means “to believe”.
Debit: It’s a Latin word meaning “to owe”.
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3.6.1 Cash
“Money is a standardized unit of exchange”. The practical form of money is currency or
cash. Currency varies across countries whereas money remains the same. For example,
in India, the currency is the Indian Rupee (INR) and in the US, it is the US Dollar (USD).
Cash or Currency has been the predominantly used medium of payment across the
globe until the advent of cards. The modern day currency was originally preceded by
drafts and bills, which were the two ancient forms of paper money. The former were
basically receipts for certain value, while the latter were a promise to convert to certain
value at a later date. Cattle and grain were the oldest forms of exchange, as per the
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Barter System. Drafts in the form of metals were used as far as 1 BC in Ptolemaic Egypt.
Paper money came into being to make up for coin shortages.
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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.
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
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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
Address Preetum
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• It must contain an order to pay. Words like ‘please pay Rs 5,000/- on demand
and oblige’ are not used.
• The order must be unconditional.
• The order must be to pay money and money alone.
• The sum payable mentioned must be certain or capable of being made certain.
• The parties to a bill must be certain.
3.6.3 Cheques
The Negotiable Instruments Act, 1881 defines a cheque as “a bill of exchange drawn on a
specified banker and not expressed to be payable otherwise than on demand” . Actually, a
cheque is a debit based instrument in the form of written order by the account holder
of the bank directing his banker to pay on demand, the specified amount, to or to the
order of the person named therein or to the bearer.
Following is a specimen of a check.
<Date>
Pay…………………………………………………………………………..
……………………………………………………………………or Bearer
Rupees………………………………………………………………………
……………………………………………………………...Rs……………
CANARA BANK
Banjara Hills,
Hyderabad
MSBL/99
65303 110002056 10
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Features of a cheque
• A cheque must be in writing and duly signed by the drawer.
• It contains an unconditional order.
• It is issued on a specified bank only.
• The amount specified is always certain and must be clearly mentioned both in
figures and words.
• The payee is always certain.
• It is always payable on demand.
• The cheque must bear a date otherwise it is invalid and shall not be honored by
the bank.
Types of cheques: Broadly cheques can be categorized on the basis of ownership or on
the basis of timing of issue.
On the basis of ownership cheque has following four sub-categories.
a) Open cheque.
b) Crossed cheque.
c) Bearer cheque.
d) Order cheque.
a) Open cheque: A cheque is called ‘Open’ when it is possible to get cash over the counter
at the bank. The holder of an open cheque can do the following:
• Receive its payment over the counter at the bank,
• Deposit the cheque in his own account
• Pass it to some one else by signing on the back of a cheque.
b) Crossed cheque: Since open cheque is subject to risk of theft, it is dangerous to issue
such cheques. This risk can be avoided by issuing another type of cheque called
‘Crossed cheque’. The payment of such cheque is not made over the counter at the
bank. It is only credited to the bank account of the payee. A cheque can be crossed by
drawing two transverse parallel lines across the cheque, with or without the writing
‘Account payee’ or ‘Not Negotiable’.
c) Bearer cheque: A cheque which is payable to any person who presents it for
payment at the bank counter is called ‘Bearer cheque’. A bearer cheque can be
transferred by mere delivery and requires no endorsement.
d) Order cheque: An order cheque is one which is payable to a particular person. In
such a cheque the word ‘bearer’ may be cut out or cancelled and the word ‘order’ may
be written. The payee can transfer an order cheque to someone else by signing his or
her name on the back of it.
On the basis of timing of Issue checks can be put into following subcategories.
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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.
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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
• In open check it is possible to get the cash over the counter of the bank
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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.
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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.
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UNA
UNB UNZ
• 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.
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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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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.
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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.
9.9.1 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
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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)
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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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• 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.
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Example:
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Source: http://www.swift.com/index.cfm?item_id=60134
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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
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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.
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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.
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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.
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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
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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.
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.
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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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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.
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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.
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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.
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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.
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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
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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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Figure 12.4 Average Daily Volumes and Value of CHIPS Source: www.chips.org
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• 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.
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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.
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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.
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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.
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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.
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!
12.16.3 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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12.17 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
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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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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.
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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.
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Figure 19.2–Mobile Payment Life Cycle Source: Mobile payment Forum white paper
Local business is high growth emerging segment for the mobile transactions.
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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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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
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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.
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• In PayPal all the financial information are accumulated and are kept under one
category so that it causes no hardship while looking for any reference
• PayPal eases online payments by using different credit cards
• PayPal make payments directly from one’s bank account, and reduces the chances
of any confusion in the bank balance
• No more hassle of typing credit card numbers every time while making a purchase
• PayPal is faster than money orders and checks.
PayPal is trusted worldwide
• PayPal online Payment System has more than 133 million member accounts
• PayPal is used across the world in 103 countries and regions
• It is widely accepted on merchant websites.
PayPal is safe
• In a PayPal transaction, the financial information of the user is never shared
• Sellers do not see credit card or bank account numbers in a PayPal Payment
System
• PayPal Fraud prevention team fights pr-empts fraud occurrence and thus makes the
system more secure.
DID YOU KNOW?
Security
After a series of scams, PayPal formulated a plan to prevent criminals from using
computer programs to open dozens of fraudulent accounts with stolen credit card
numbers. This system, known as the "Gausebeck-Levchin" test, is now widely used by
thousands of Web sites [ref]. It requires new account creators to type in a word found in
a small image file on the account creation page. A script or a bot can't read this word --
only a human can decipher it.
The Gausebeck-Levchin test on PayPal: The sight-impaired (who use text-based Web
browsers) can listen to a recording of the letters instead.
PayPal also uses special programs to detect potentially fraudulent activity. These
programs watch for certain red flags that might be a sign of fraud. These red flags
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include sudden increases in volume or quantity of transfers, denied credit card charges
or invalid IP addresses.
Source: www.paypal.com
PayPal is cost-effective
• All purchases using PayPal is free of charge
• Affordable pricing for all businesses.
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Ø Funds are transferred securely through PayPal and money is deposited into the
seller's PayPal account
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Email Payments
To start accepting payments using Email Payments, merchant needs to set up one or
more of the payment processing options. A merchant can select as many additional
features as per his business needs.
Web Accept Based Payments
Accepting payments on a website with PayPal is as simple or as complex as one wants
to make it. At the basic level, though, setting up an e-commerce site with PayPal is very
straightforward and requires only a working knowledge of the website’s HTML code in
order to be successful.
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Free for bank accounts in the US. Free for bank accounts in the US.
Withdraw Funds
Fees for other banks Fees for other banks
Receive payments
funded by PayPal
Free 1.9% to 2.9% + $0.30 USD
Balance, PayPal Instant
Transfer or PayPal eCheck
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PayPal charges fees only to the sellers and not buyers. PayPal charges fees based on the
total amount of money paid, not on the selling price of the item. That means if a $10
item has a $5 shipping/handling cost, the buyer pays PayPal a total of $15—and PayPal
bases its fee on that $15 payment. Accordingly, PayPal fees would be computed on the
total cost of item price plus shipping costs.
The three PayPal account types differ in some important ways as described earlier in
this Section.
However, all have access to PayPal's core features, which include:
Ø Send Money
Ø Request Money
Ø Auction Tools
Ø Website Payments
Ø Money Market
Ø Virtual Debit Card
Ø Account Insurance
Ø E-mail Customer service.
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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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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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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
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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.
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.
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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.
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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.
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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.
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Gateway
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• The Merchant sends a request for batch administration to the Payment Gateway
• The Payment Gateway’s response to this request.
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As payment instruments evolve and the transaction volumes up, the complexity of
interaction will also increase.
Internet
Payment
Gateway
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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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.
1.1.6 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.
1.2.2 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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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
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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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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.
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
Cost
Rs 75,000 or Rs 75,000 or
Set Up Rs 20000/-
greater greater
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Support
24 x 7 Helpdesk YES NO NO
MIS Interface
Compehensive MIS Interface YES YES YES
Inital Signup
Transaction Features
Source: Paymentgateway.org
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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.
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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!
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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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– 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.
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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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.
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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.
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.
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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.
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certificates, funds deposited are remotely stored on the users actual card, which is not
linked to any central account. In addition, the electronic wallet that accompanied the
card allows the value on the card to be transferred from person-to-person indefinitely
without any central verification or clearing requirement, making it the closest in
operation to real cash. It also has the additional ability to store the recent payment
history.
Visa-Cash - The Visa Cash is similar to Mondex. However Visa Cash payments are routed
through a central facility and cannot be transferred from card to card with the same
degree of ease. One major point in its favor is its appeal to banks as it allows them to
earn float income; therefore Visa Cash is more attractive from a purely commercial point
of view.
Digi-Cash - The Digicash Company was based in the Netherlands after being
established in 1990 by David Chaum. The e-money product of the company was called
eCash. To use eCash, an account should be established at a DigiCash-licensed bank with
real money. Once established, the customer can withdraw eCash that is stored on the
user computer's hard drive. Using proprietary software, eCash can be spent with an
Internet merchant or with anyone else whose computer is set up to deal in eCash.
However all such transactions must be made through an intermediary bank. One of the
cornerstones of the Digicash system is its insistence on the maintenance of privacy. The
system uses blind signatures as the way for the issuing bank to certify each token it
issues. The actual process requires the customer, not the bank, to generate the eCash
token. The customer creates blank tokens and forwards them (hidden in a digital
envelope) to the bank for certification. The bank stamps its signature on each token,
debit the customers account and sends the token back over the Internet. So the digital
tokens can be registered and verified by the issuer without revealing to whom it was
originally issued. In effect, these digital cash transactions are capable of being as
anonymous as cash. Because the system is software based, it is therefore relatively easy
to duplicate certified eCash tokens. Therefore to guard against this, any eCash
presented for payment is crosschecked with the central registrar to ensure it has not
already been spent. It seems it is impractical for most merchants and customers and
this has limited its application in the market.
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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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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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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.
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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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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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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
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reason why they are now seeking to develop real time gross settlement systems to
handle high-value payments.
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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).
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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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.
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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.
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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.
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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.
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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.
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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
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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.
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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
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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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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.
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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.
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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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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
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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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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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23.5.2 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 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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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).
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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.)
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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.)
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.)
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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.
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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.
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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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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.
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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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within 14 days.
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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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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.
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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.
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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.
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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
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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.
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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.
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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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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.
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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).
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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.
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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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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
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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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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.
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Having looked in the previous session (Session 3) at the various means by which a
payment can be initiated, this session examines what happens to that payment
instruction - how it is exchanged between the sending and receiving banks; and how
those banks settle between themselves so that the receiving customer’s account gets
credited.
CLEARING: The process of transmitting, reconciling and in some cases confirming
payment orders or security transfer prior to settlement.
However, for the purpose of this session on Clearing & Settlement we refer to only cash
transactions and exclude securities clearing and settlement from our scope.
SETTLEMENT: refers to the act of transferring “good and final funds” between two
parties.
TYPES OF SETTLEMENT:
1. Designated-time net settlement (DNS): in this running balances are calculated on a
bilateral or multilateral basis for each participant vis a vis the other participants and
only net amounts are settled at pre-specified times during the day
2. Real Time Gross settlement (RTGS): Settlement of funds occurs on a transaction by
transaction basis continuously in real time without netting debits against credits.
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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
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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.
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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.
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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.
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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
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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.
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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.
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.
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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.
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payment message is automatically relayed from the sending bank’s gateway to the
receiving bank.
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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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